Arizona real estate attorney William A. Kozub wrote an article called “Civil & Criminal Issues with Commercial Leases in the Medical Marijuana Industry” published on the Arizona School of Real Estate & Business website. It’s recommended reading for landlords, real estate brokers, realtors and others who are involved with or considering becoming involved with a lease of Arizona land to a medical marijuana dispensary or a medical marijuana grow facility. Here are some statements made in the article:

“all owners, agents and property managers who have sought to reap the benefits of the medical marijuana industry must also be aware of the significant civil and criminal risks inherent in this industry, risks that arise from the fact that federal law does not recognize the medical use of marijuana. . . . While a criminal prosecution of the landlord may not occur, the landlord’s building may find that it is a named defendant in a forfeiture proceeding. Federal law clearly provides for the seizure of ‘all real property, including any right, title, and interest (including any leasehold interest) in the whole of any lot or tract of land and any appurtenances or improvements, which is used, or intended to be used, in any manner or part, to commit, or to facilitate the commission of, a violation of this subchapter punishable by more than one year’s imprisonment’.”

Nonprofit entities that want to obtain a dispensary registration certificate (aka license) to sell medical marijuana in Arizona have a lot of tasks to accomplish before they can open for business. At this time, however, the single most important task for all would-be dispensaries is to locate a properly zoned place within the desired CHAA to operate the dispensary and tie it up with a lease or an option to lease.

Arizona’s medical marijuana law and the Arizona Department of Health Services rules provide that the application for a dispensary registration certificate must show the location where the dispensary will operate. In addition, Arizona Department of Health Services Rule R9-17-304 states:

To apply for a dispensary registration certificate, an entity shall submit to the Department the following

6.Documentation from the local jurisdiction where the dispensary’s proposed physical address is located that:

a. There are no local zoning restrictions for the dispensary’s location, or

b. The dispensary’s location is in compliance with any local zoning restrictions;

7. Documentation of:

a. Ownership of the physical address of the proposed dispensary, or

b. Permission from the owner of the physical address of the proposed dispensary for the entity applying for a dispensary registration certificate to operate a dispensary at the physical address;

Translation: The dispensary applicant must obtain and submit with the application for a dispensary registration certificate a written statement from the applicable zoning authority that the proposed dispensary premises is “groovy” and a written statement from the landlord that the applicant can operate a dispensary at the location designated in the application (or proof the applicant owns the land).

Actions Prospective Dispensaries Must Take Yesterday

Here are the actions every would be dispensary must take as soon as possible:

1. Hire a zoning attorney who can tell you which locations in your desired CHAA are properly zoned and meet the requirements of the ADHS rules. This step is very important because it is a total waste of time to search for a location and get it leased and find out the location is not properly zoned or too close to a school. The zoning attorney will also apply for the Rule R9-17-304.D.6 zoning comfort letter from the applicable zoning authority.

2. Visit only properly zoned sites that are not too close to a prohibited structure and identify where you want to operate the dispensary.

3. Sign a lease or an option to lease for your desired location (or enter into a contract to purchase it). Make sure the lease has language in it that requires the landlord to give you a written Rule R9-17-304.D.7 comfort letter not later than April 1, 2012.

Cities are severely limiting the areas where a dispensary can be located. When you add the complexity of understanding the applicable zoning ordinance with the further limiting CHAAs, the result is a very difficult problem simply to determine where dispensaries can be located within a CHAA. In many CHAAs, the number of usable sites is limited, which is causing a modern day equivalent to the Oklahoma land rush of the 1800s.

If you cannot find a location and legally tie it up with a lease or a lease option, it’s game over. If your dispensary has not yet found and tied up a site, you should immediately contact an experienced zoning lawyer to explain the zoning rules for your desired area and show you how the CHAAs interact with the zoning. You want the zoning attorney to give you a map that shows exactly where within a city and a CHAA the zoning is right for a dispensary. Use that map to find a site. Enter into a lease or an option to lease with the landlord. Have your zoning lawyer assist in completing the necessary city paperwork to get your site approved by the city.

Nothing else matters as much now as finding a site that is properly zoned and getting it under lease or an option to lease.

I recommend Maricopa County zoning attorney Michael Curley. Call him at 602-903-3077. You need a zoning lawyer to explain where you can lease your site and what locations are available in your desired CHAA.

One of the important provisions included in my Addendum to Lease between a landlord and a tenant that intends to operate an Arizona medical marijuana dispensary is a condition that requires the landlord to deliver to the tenant a Nondisturbance Agreement from every person or entity that holds a deed of trust or a mortgage on the premises. If your not-for-profit dispensary entity intends to lease premises for the dispensary or the growing facility, a Nondisturbance Agreement from every lienholder is a must have document. This document protects the tenant from being evicted if the landlord loses the real property in a foreclosure.

Under Arizona real estate law, when the landlord defaults on a lien that encumbers real estate, the lienholder can foreclose and the land is sold to the highest bidder. The legal consequences of a foreclosure is that the foreclosure terminates / extinguishes the interests in the land of every party whose interest is of a lower priority than the foreclosed lien. Translation: If a lienholder whose lien was recorded before the tenant entered into a lease forecloses, the foreclosure terminates the lease.

Solution: If the premises your nonprofit entity leased or intends to lease are encumbered by one or more Deeds of Trust or Mortgages, the entity must get a Nondisturbance Agreement from every lienholder. This is an agreement signed by the lienholder in which the lienholder promises that if the lienholder forecloses on its lien, it will honor the tenants lease as long as the tenant does not default on the lease.

Example 1. Landlord borrows $X from Lender on January 1, 2011. The loan is secured by a Deed of Trust that encumbers the land of which the leased premises is a part. The Deed of Trust is recorded on January 3, 2011. Landlord leases premises to dispensary on March 4, 2011. Landlord defaults on the payments due to Lender on January 1, 2013. Lender forecloses by selling the property at an auction held by the trustee under the Deed of Trust on May 1, 2013. The foreclosure terminates the lease as of May 1, 2013. If the tenant cannot make a deal with the new owner to stay in the premises, the tenant will be out on the street and the dispensary will die. If the tenant can work out a new lease with the new owner, the new rent will probably be a lot higher because the new owner has the tenant over a barrel.

Example 2. Same facts as above except the lease required the landlord to get a Nondisturbance Agreement from the Lender and the Lender signed and delivered the Nondisturbance Agreement to the tenant. The tenant recorded the Nondisturbance Agreement on March 4, 2011. The foreclosure does not terminate the lease and the new owner becomes the new landlord and cannot evict the tenant as long as the tenant satisfies all of the tenant’s obligations under the lease.

Warning #1: During these difficult economic times, many landlords are defaulting on their loans. Do not take a chance that you might lose your entire investment in your Arizona medical marijuana dispensary because your landlord defaults on a loan. Your dispensary must get a Nondisturbance Agreement from every lender that holds a lien that was perfected before the date of the lease because the failure to do so could cause the loss of your entire investment in the dispensary if the landlord defaults and the property is sold at a foreclosure sale.

Warning #2: You can ask the landlord to disclose the existence of liens and the name and address of the lienholder(s), but the only safe way to determine if a lien, Deed of Trust or Mortgage encumbers your leased premises is to pay a title insurance company to give you a status report that lists all liens and encumbrances on the leased premises. If the landlord tells you there are no liens and you don’t verify that fact independently, you’ll wish you had purchased a status report from a title insurance company when the property sells at a foreclosure auction and your dispensary is evicted from the premises.

Solution: Every would be dispensary that leases premises that are encumbered by a lien must protect itself from potential eviction due to the landlord’s default on a lien by obtaining a Nondisturbance Agreement signed by the lienholder.

If you have already signed a lease, it’s not too late to ask the landlord to ask the lender to give you a Nondisturbance Agreement, but the landlord and the lender are less likely to to it if it is not a condition to the effectiveness of the lease.

Question: My landlord wants the owners of my Arizona medical marijuana dispensary nonprofit entity to sign a Personal Guaranty. What is it and should the owners sign the guaranty?

Answer: A Personal Guaranty is a promise by the guarantor to pay the debt of a third party or to satisfy an obligation of a third party. If an entity such as a corporation or a limited liability company signs a lease for real property, the general rule of Arizona law is that the owners of the entity are not liable for the debts or obligations of the entity, including the rent. Landlords understand the law so a prudent landlord will require the owners of the entity to sign a Personal Guaranty by which the signer becomes legally obligated to pay to the landlord any amounts due under the lease that are not paid by the tenant and to satisfy any obligations of the tenant under the lease that are not satisfied. The landlord usually wants all of the owners of the tenant entity to sign a Personal Guaranty.

Personal Guarantees of leases are not required by Arizona law. Whether or not the owners give a personal guaranty is negotiable with the landlord. In economic times that favor landlords, they almost always require the owners of the tenant entity to sign a Personal Guaranty unless the entity has a satisfactory financial statement. During economic times that favor tenants, i.e., now, the owners of the entity may refuse to sign a Personal Guaranty and a desperate landlord may nevertheless enter into the lease without any Personal Guarantees because the landlord needs the rental income.

Personal Guaranty Negotiating Advice

Here are some negotiating tips for owners of an entity that may reduce their liability for the entity’s defaults under the lease when the landlord insists that the owners sign a Personal Guaranty:

Reduce the term of the Personal Guaranty. Just because the lease is for five years does not mean the Personal Guaranty must last the same period of time. Try to shorten the term of the Personal Guaranty to some period less than the full term of the lease.

Don’t guaranty extensions of the lease. If the original term of the lease expires and the entity exercises an option to extend the term of the lease, include language in the Personal Guaranty that it does not apply with respect to any extensions of the lease.

Limit the maximum dollar amount of the signer’s liability. State in the Personal Guaranty that the maximum amount for which the signer is liable is $50,000 or $100,000 or whatever is the lowest number the landlord will agree to. If the landlord spends the landlord’s money for tenant improvements or for other items required of the landlord, the landlord will almost always want the landlord’s total out-of-pocket expenses to be the signer’s minimum liability.

If the landlord will agree to limit the signer’s liability to a stated amount, provide in the Personal Guaranty that the amount of the liability goes down each month. For example, if the signer’s maximum liability is $120,000 and the term of the Personal Guaranty is two years, provide in the Personal Guaranty that the signer’s liability goes down $5,000 every month.

State in the Personal Guaranty that the signer’s obligations terminate as of the date the entity loses its license to operate an Arizona medical marijuana dispensary.

State in the Personal Guaranty that the signer’s liability terminates if the signer were to die.

State in the Personal Guaranty that the signer’s total liability is equal to the total liability thereunder divided by the number of other owners who sign a Personal Guaranty. For example, if the entity has four owners who will sign guarantees, state that the signer’s total liability under the Personal Guaranty equals 25% of the total liability.

State in the Personal Guaranty that if the Arizona Cardinals with the Superbowl, the Personal Guaranty will terminate. A knowledgeable landlord should not have a problem with this because the landlord knows there is almost no chance this will ever happen.

Important Fact About Personal Guarantees & Arizona Community Property

Arizona law provides that a Personal Guaranty signed only by one spouse is not effect against the assets of the non-signer spouse. If the landlord requires that both spouses sign the Personal Guaranty, try telling the landlord that the spouse who is not active in the business refuses to sign a guaranty.

Question: I know that in 2007 the U.S. Tax Court ruled in the CHAMPS case that Section 280E of the Internal Revenue Code prohibits deducting from gross income any business expenses that are paid or incurred in connection with trafficking in marijuana. Is there a way that my nonprofit entity that operates an Arizona medical marijuana dispensary can deduct any of its expenses from its gross income on the dispensary’s federal income tax return?

Answer: Yes. In the CHAMPS case, the IRS conceded that the taxpayer could deduct its cost of goods sold, which included $575,317 paid for marijuana. The fight in the CHAMPS case was over what business expenses the taxpayer could deduct. The IRS argued that the taxpayer had only one business – trafficking in marijuana – and therefore none of its business expenses other than its cost of goods sold were deductible. The taxpayer successfully argued that it operated two businesses – its medical marijuana sales business and its care-giver business. The Tax Court agreed with the taxpayer and allowed the taxpayer to allocate its expenses to its two separate businesses and deduct expenses attributable to the care-giver business.

If your Arizona medical marijuana dispensary wants to be able to deduct anything from its gross income above and beyond its cost of goods sold, the dispensary must engage in one or more trades or businesses that do not involve medical marijuana. Every would-be dispensary should carefully study the CHAMPS case and learn how CHAMPS operated its care-giver business, which was very extensive and real. The case illustrates that the sale of medical marijuana was in fact a small portion of everything that the dispensary offered to its patients. Note also that the salaries paid to management and staff were very nominal – $14,914 paid to officers and directors and $44,799 salaries paid to 25 employees of a dispensary that collected just over $1,000,000 in gross revenue.

Example 1: Dispensary 1 operates a 2,000 square foot retail dispensary in Phoenix where its sole activity is displaying its products and selling products to patients over the counter. This dispensary’s entire business involves trafficking in marijuana so it cannot deduct any of its expenses from its federal income tax return.

Example 2: Dispensary 2 operates a 2,000 square foot retail dispensary in Phoenix, but next door to the dispensary it has an additional 2,000 square feet of space where it provides other services and products to the public such as:

yoga classes

acupuncture

massage therapy

classroom instruction on the use of medical marijuana and other pain medications

classroom instruction on health care related topics

library of books, DVDs and other materials about medical marijuana that patients of the dispensary can use for reading on the premises or to check out and view at home.

coffee bar with pastries where people can congregate and relax

Dispensary 2 can now:

allocate occupancy expenses to retail and nonretail

allocate payroll expenses to retail and nonretail

apply a transactional factor

Consider this simple allocation of dispensary 2’s expenses:

Since 1/2 of the leased space is not used for the sale of marijuana, fifty percent of the total rent expense is deductible. This includes ancillary expenses such as security for the premises, utilities, landscaping, common area expenses and maintenance, janitorial service and premises maintenance.

Dispensary 2 can deduct its payroll expenses attributable to personnel who work solely in the non-marijuana side of the business. For personnel that work in both aspects of the business, the dispensary must have a method for allocating their payroll to the marijuana related services and the non-marijuana related services.

Although I have a masters degree in income tax law from New York University Law School, I am no longer a practicing tax lawyer. I recommend that every dispensary hire a good experienced tax CPA or tax lawyer to advise the dispensary on the federal and state income tax issues arising from the operation of a medical marijuana dispensary.

Circular 230 Notice: Pursuant to recently-enacted U.S. Treasury Department regulations, I am required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including websites linked to, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Question: I own real property that is zoned for an Arizona medical marijuana dispensary or cultivation site. How can I increase the chances of obtaining a tenant that will actually obtain a dispensary registration certificate and become a long term paying tenant?

Answer: Easy. Lease your property to more than one prospective dispensary owner. Consider the following two scenarios:

Scenario 1: You lease to prospective dispensary owner number 1. The prospective tenant includes a clause in the lease that allows the tenant to terminate the lease if the tenant does not obtain a dispensary license. The tenant does not obtain a license. Long term rental income = $0.

Scenario 2: You lease the same site to 20 prospective dispensary owners. Each prospective tenant includes a clause in the lease that allows the tenant to terminate the lease if the tenant does not obtain a dispensary license. One of the 20 prospective tenants obtains a license to operate an Arizona medical marijuana dispensary. Nineteen prospective tenants leases are canceled. Long term rental income = big $$. Of course, each lease should have appropriate language in the lease that notifies each prospective tenant that its lease only becomes effective if the tenant actually obtains the dispensary registration certificate.

Update: A visitor to this website sent me the following message:

“I thought of this a couple of weeks ago and checked with the AZ Department of Health Services. The first person I spoke with was an employee of the department. She told me that multiple license applications with the same address would all be rejected. I then spoke with Laura Oxley the head of the department. She said it was a good idea, but I should speak with Tom Salow the department attorney for medical marijuana. Tom said that what I was proposing was currently acceptable under the guidelines, but he expected the guidelines to change making it unacceptable in the next revision.”

If Tom Salow’s statement about is true, why would the Arizona Department of Health Services reject multiple applications for the same location? It would not make any sense. The only purpose behind such a rule would be to make it more difficult for prospective dispensaries to find a suitably zoned location and to cause a lot of landlords to waste time entering into leases with tenants that will never get a dispensary registration certificate. If DHS changes the rules to reject applications for the same location, it would be another instance of the Arizona Department of Health Services bureaucrats/desk jockeys being the problem, not part of the solution.

Developing your business plan in anticipation of filing an application with Arizona Department of Health Services ? If so, you’re likely scrambling to find the perfect location(s) for your new Arizona medical marijuana business. Whether you’re seeking a storefront or a warehouse, there are three things about insuring building(s) for dispensaries, grows or other medical marijuana business uses you should know going in:

“Admitted carriers” such as Progressive or Farmers will not insure medical marijuana businesses – period. They have made a business decision to not serve specialty markets.

A few other carriers might insure your leased or owned buildings, depending upon the specific circumstances. They are willing to take on more risk, but the medical marijuana industry is not their specialty.

Comprehensive coverage for your medical marijuana business, written with A-rated carriers, IS available from agents and insurers who have made a commitment to the medical marijuana industry.

Let’s keep these few facts in mind as we discuss the best way to protect yourself and your future business through the uncertainties of the current pre-DHS application period.

Getting Into the Building

Many landlords require proof of property and liability insurance before giving their new tenants access to the building. This is prudent, and generally required under the terms of the building owner’s “lessor’s risk” policy.

Your future landlord needs to know that claims against that policy resulting from MEDICAL MARIJUANA business activities aren’t likely to pay out, however, as suggested in the first bullet point. While it’s their responsibility to discuss any tenant changes with their agent, I always advise my clients to bring the topic up so that everyone is on the same page, helping all parties to avoid any nasty surprises later.

Insuring Appropriately Now While Planning for Later

While waiting to find out if you’ll receive a dispensary license from DHS, you need only insure yourself against liability, any damage to your newly leased property and loss or damage to property you may have in the building. Simply put, basic coverage is sufficient for this stage.

Many carriers will write a policy for empty office or warehouse space, but offer only a one year term – and given that it will be just a few months before you receive your dispensary license (or not) this doesn’t make a whole lot of sense, especially as they will charge you a short-rate penalty for cancelling before the end of the term.

A better approach is to obtain your basic policy now from a carrier that won’t penalize you later, when you’re ready to begin insuring your new MEDICAL MARIJUANA operation with industry-specific coverage. You can either get a basic six-month policy that can be “flipped” to another carrier (under the same parent company) to one that specifically includes coverage for MEDICAL MARIJUANA businesses, or get a pared down policy from a company specializing in MEDICAL MARIJUANA policies and simply add additional coverage as needed. Either approach will help you to avoid unnecessary penalties or fees while ensuring that your new venture is appropriately covered.

Such flexibility in coverage costs a bit more, but provides several significant benefits – no risk of denied claims due to undeclared MEDICAL MARIJUANA operations, eliminating the danger of coverage gaps or lapses, and simplying the whole insurance process – all far outweigh the small additional costs.

The majority of carriers serve the majority of the market. If your business is out of the ordinary, however, your insurance needs likely are as well. Specialty brokers meet those needs.

Question: Must I know my Arizona medical marijuana dispensary and cultivation locations before I file my application with Arizona Department of Health Services to obtain a dispensary license?

“Not later than ninety days after receiving an application for a nonprofit medical marijuana dispensary, the department shall register the nonprofit medical marijuana dispensary and issue a registration certificate . . . if . . . The prospective nonprofit medical marijuana dispensary has submitted . . . an application, including:

(i) The legal name of the nonprofit medical marijuana dispensary.

(ii) The physical address of the nonprofit medical marijuana dispensary and the physical address of one additional location, if any, where marijuana will be cultivated, neither of which may be within five hundred feet of a public or private school existing before the date of the nonprofit medical marijuana dispensary application.”

Therefore, Section 36-2804 requires that the application state the name of the dispensary owner and the actual address where the dispensary will sell to patients and where it will grow its marijuana. Now is the time for all prospective dispensaries to be looking for an buying or leasing the premises where they will operate and grow. Once you find a site, if the site makes sense and if the zoning allows for the use of the site for a dispensary or cultivation site, you must tie up the site, i.e., enter into a legally binding lease for the premises or a contract to buy it.

Note: Before you find your site, you must have formed you limited liability company so that it can be the party that signs the lease or purchase contract. You do not want the personal liability that goes with being the singer on a lease or contract. If you need me to form your Arizona limited liability company, see the links near the top of the right column of this website.

Because no applicant will know if the applicant will actually receive a dispensary license, it does not make sense for the dispensary to enter into either a lease or a contract to buy unless the lease or contract contains provisions that are unique to the medical marijuana business. For example, you want a clause in your lease or purchase contract that gives you the option to terminate the lease or purchase option if you do not actually get a license or if you get a license and later lose the license and cannot get it back. You’ll want a use clause that is appropriate for the business as well as clauses that allow you to make tenant improvements and take actions inside and outside the premises that are necessary to comply with Arizona’s medical marijuana law and the ADHS rules.